Risk-sharing, hubris, and a possible Grexit from the Eurozone

The new Greek Finance Minister Mr. Varoufakis, a reputable game theorist with deep knowledge of the Eurozone crisis, has been recently touring European capitals to drum up support for his plan to handle the Greek debt crisis.

His strategy is to take advantage of the anti-austerity mandate of the newly elected government in Greece to force creditors to renegotiate the entire framework of the bailout agreement between Greece and its creditors. That is why he refused to enter the 5th and final review of the bailout program by the troika, thus rejecting the last 7.2 billion Euros due to Greece if the review is successfully concluded. He does not want to make a move within the current framework. He wants to change the framework itself. He wants to force a paradigm change.Will he succeed? He has certainly forced the issue of austerity on the European agenda. Several sympathetic articles have been written in international newspapers by reputable analysts, who have pointed out the failure of the current bailout program. Austerity, at least, becomes widely debatable. Mr. Varoufakis is likely to get a few concessions from creditors when the question of debt relief is decided. But the Eurozone is not an academic seminar, in which Habermasian “ideal speech” conditions prevail. The terms of debt relief for Greece will be decided, ultimately, by politics. Power is what matters, and power is with creditors, not Greece. The fundamentals of the bailout program are unlikely to change. Meanwhile, the program expires on 28/2/2015 and if Greece is not in it, its banks will be hugely exposed and the country will run out of cash.Varoufakis has long been arguing, quite rightly, that the debt crisis that has gripped the European south is a crisis of the entire Eurozone, not merely a crisis generated entirely within the countries directly affected. The Eurozone is a flawed structure. There is a common currency but no fiscal union and certainly no political union. The pillars sustaining the edifice are ill-designed. However, this is not the diagnosis of the most powerful member of the Eurozone, Germany. The German Finance Minister said as much recently (5/2/2015): the causes of the Greek crisis are to be found within Greece, not elsewhere. This is partly true. The other part, however, not mentioned, is that a monetary union of countries so widely different in productivity, competitiveness and institutions is bound to be shaky. In a monetary union, trade surpluses in a rich country are closely linked with trade deficits in a less competitive economy. A currency union that is unsupported by common fiscal and political institutions creates collective action problems and an unequal sharing of risks (as rightly pointed out by the Bank of England governor M. Carney). The result is economic misery, the rise of political extremism and instability.Is Mr. Varoufakis’ plan for handling the Greek debt crisis sound? On purely economic grounds, it is. So say some of the most reputable economists, such as the Nobel laureate P. Krugman and astute analysts such as Martin Wolf of the Financial Times. Greek debt is simply unsustainable. No country, especially Greece with its several institutional flaws, can pay back a debt as high as 175% of its GDP. Growth is needed, but the bailout austerity program has delivered misery so far – 26% unemployment (50% youth unemployment), contraction of the economy by 25%, decrease of Greek spending power by 40%, a near-collapse of pension funds, lots of new taxes, and so on. Rightly, several economists draw the analogy between the depression in the USA in the 1930s and the current Greek situation. Another analogy is between austerity-stricken, extremism-riven Greece and the poverty-stricken Weimar Republic in Germany, in the interwar years that led to Nazis’ rise. Anyone who knows life in Greece today knows that there is a lot of suffering, massive hopelessness and rising political extremism.However, the main assumption northern Eurozone members make is that Greek debt is sustainable. Varoufakis, quite rightly, has been arguing for the opposite. His idea of swapping Greek debt with new bonds linked to growth is sensible and has been tried in other heavily indebted countries in the past. Importantly, it is a way of sharing risk in the Eurozone. What is disappointing in the creditors’ (especially German) attitude is their aversion to share risk with the indebted south, especially Greece. This is, ultimately, a political question, which is swept under the carpet, or, at least, couched in technocratic language. The real source of the problem is that the euro is not supported by a political community that is willing to share risks.Germany hides itself behind formalities such as “keep your commitments and stick to the agreements Greek governments have signed”. While this is important, it is also important to acknowledge that the current austerity program does not work. Political leaders should have the courage and the vision to revise plans, to adapt to realities as they unfold. Yes, Greek governments have been incompetent, protective of special interests and the oligarchs, while tax evasion and corruption are chronic problems. That is hardly new and unexpected for anyone knowing Greek politics. But austerity in itself is a huge problem too. The problem is that northern Eurozone members do not trust Greece that it will deliver on reform needed to stimulate growth. They have good reasons for this. Greek governments have been dragging their feet on structural reform, which, at the very best, only reluctantly accepted (and not always enacted). Thus, even if creditors were prepared to offer a substantially better financial deal to Greece, they are, partly at least, prevented from doing so by their lack of trust in Greek governments.Notice the looming impasse: several key Eurozone players want Greece to keep its commitments and stick to a bailout program whose harsh terms and conditions have generated widespread suffering for Greeks. Being a group of sovereign countries rather than a single country, Eurozone faces a collective action problem: they are unwilling to share risks and are prepared to settle to the lowest common denominator (“agreements should be kept”), rather than face reality and revise agreements. To do the latter would be politically risky, since it may open Pandora’s box – certain countries (like Portugal) have already incurred great costs by sticking to the bailout program, others (like Cyprus) may ask for a more relaxed treatment like Greece’s, while others (like Spain and France) fear that their populist opposition parties may benefit if rules are relaxed. In short, once the agreed rules begin to relax, there is a fear that this may be a self-feeding process, at the expense of fiscal discipline. Given the suspicion in which the profligate south is held by the fiscally virtuous north, sticking to the rules appears to be the optimal strategy for the powerful members of the Eurozone. Adhering to what has been agreed maintains peace, albeit a very costly and precarious peace. Thus, it is not surprising that “sticking to the agreements” (i.e. to the harsh bailout program) seems to be the equilibrium point for a pool of countries, keen to protect their national interests and wanting, at the same time, to preserve their pool. Bureaucratic inertia has incentives to prevail.On the other hand, the Greek government wants its bailout terms to relax but is unable to convince Germany and its allies that Greece is a trustworthy partner who will deliver on reform. How could Mr. Schauble have faith in the Tsipras government when his party has been against every reform of the economy and the state in the last six years? How could Mrs. Merkel trust a Greek coalition government that consists of a populist left party (Syriza) wanting to enlarge the role of the state in the economy and a populist far-right party (Independent Greeks) that has been describing Mrs. Merkel as a Nazi, is deeply nationalistic and intensely xenophobic? In short, the current (and the previous) Greek government cannot deliver what Germany and its allies need most: credibility and determination to carry through structural reforms.How will the Greek crisis unfold? It appears that Germany will intransigently insist on Greece sticking to the bailout program and the harsh financial conditions it imposes. The Greek government was recently elected with the mandate to renegotiate the entire framework of the bailout program. The two parties cannot agree, or, as Mr. Schauble recently said (5/2/2015), they “have agreed to disagree”.The future of Greece depends on its baking system. When the 28/2/2015 deadline comes, and if Greece is not in the agreed bailout program, ECB will need to decide on whether it should allow Greek banks to draw funds from Emergence Liquidity Funding (this was the dilemma they put to the Cyprus government in April 2013, forcing it to accept a bail in). If ECB switches off the liquidity tap, there will be death by financial asphyxiation and an almost certain Grexit. My sense is that Tsipras will not back off, for if he does, he knows he will incur the fate of his predecessor – sticking with austerity will cost him dearly. Besides, he may hope that by putting up a fight, he may ultimately force creditors to change their view, since a Grexit will be potentially disastrous for the Eurozone (a view, however, not shared by Germany who thinks the contagion effect is minimal – they could not be more wrong, by the way, but this is another matter). Unless there is compromise (which for the time being I see as difficult to be achieved), a likely scenario is for Tsipras to put whatever deal he cuts with the creditors to a referendum or call fresh elections. That will complicate things enormously, especially since, most likely, there will be a bank run and the banking system will collapse. That will be another route to a Grexit.Of course other scenaria are possible, such a national union government in Greece. I do not see this very likely, although I hope I am wrong. Of course, Europe is a continent that thrives on compromise, and a deal of some sort may be eventually reached. Moreover, Chancellor’s Merkel innate conservatism may prevail, thus making concessions to Greece in order to preserve the integrity of the Eurozone. However, if my analysis is right, the above scenaria are less likely. Creditors, most probably, will hold their position. If Tsipras holds his, a Grexit is a very probable outcome. If Tsipras compromises, he will incur significant political costs at home. The Eurozone crisis may soon reach its climax.Those who view historical actors as rational players may think that a solution will be eventually found. I hope they are right. No one can live a civilized life without believing in the power of reason. But I take a more pessimistic view of human affairs, one that has been taught by the likes of Thucydides, Sophocles, Shakespeare and Machiavelli. Major problems tend to be solved by major crises. Kings, presidents and ministers are often plagued by strategic myopia, excessive preoccupation with self-interest, and the arrogance that comes with being powerful enough to define reality. Tragedy is caused not by a failure of rationality but by hubris. We will soon see whether reason or hubris prevails. We will soon find out whether Sophocles was right in being skeptical about leaders’ ability to make wise decisions. Life teaches us wisdom, he notes, albeit after the fact.Can our political leaders be pro-actively wise? Can Greece stop its slide into misery and instability? Can the dissolution of the Eurozone be averted? If there are any statesmen in Europe, now is their finest hour.

Mr Tsoukas,
An excellent analysis of the risks involved and the brinkmanship of both sides. However, there are some points which have to mentioned in order to give a more complete picture. In my view these are the following:
1) Mr Tsipras won 36% of the vote on promises which he made knowing full well that the creditors were unlikely to accept a debt write off and abandoning the MOU which has the roadmap for reform;
2) The Greek voters in the most want to retain the Euro despite the suffering of five years recession;
3) The narrative of Germany of austerity is being questioned by more countries;
4) The attempt of Mr Tsipras to ambush the Germans was badly handled and Varoufakis going to see the British Chancellor before meeting the German Finance Minister was bad tactics;
5) The EU is pushing for growth oriented measures in infrastructure (the Junkcer plan) and recently the quantitative easing of the ECB which requires an MOU for Greece to benefit. Investments in selected sectors could have been won from the Germans by sticking to reform within the framework of an amended MOU.
6) The Troika could accept a lower fiscal surplus than the one agreed with the previous government.
7) Proposing perpetual bonds to be parked at the ECB in exchange for Troika loans was naïve; the ECB cannot fund countries in perpetuity.
Had Mr Varoufakis prepared the ground, quietly and diplomatically, to win over more countries (none have agreed with his approach on debt and he had to pull back within a week) and argued within the framework of how the Eurozone ministers politically agree matters he would have achieved more.
I believe that the Greek PM will find room to compromise since this is how the EU works and it is a matter for the two sides to find the face saving formula. I would like to believe that both sides understand the consequences of an impasse and Greece stumbling out of the Eurozone. There is room for compromise and threats from either side are harmful and cause a hardening of positions.
Greece deserves a better deal since from the start the assumptions of the IMF on debt sustainability have been time and time wrong. The solution has to be a European one and the IMF excluded; in this Germany has been convinced one hopes.

What is very disturbing is that at a time most neutral people around the world support the underdog , politicians in Greece and Cyprus are the biggest enemies of the effort made by the new Greek government as any success will show how inadequate they were in negotiating with the Troika.

Before Grexit the Greek government has the option of capital controls and bail in of bank deposits so it can gain time for negotiations.If we come to this point we will know if claims that EU is ready for a Grexit are based on reality or are just made to calm the markets and scare the Greeks.

The Greek state has an agreement with its lenders, the new Greek government has no legal right to abandon the existing agreement. Whether, the austerity measures are creating a deeper recession that can be debated, and even changes can be made by the troika. But the unilateral abandonment of the agreement by the new government is both illegal and irresponsible.

The main reason we have different productivity, competitiveness and institutions is probably because we have different cultures. Different human development. Different cultures can not always move to the same directions.
Never mind how hard EC will try, as they say to live in the “same house“, the closest they can get is to live in different rooms, and each one of them will cook in his room.
They have tried hard for so many years.
Avoiding conflicts between nations in Europe is best result so far.

You are outlining a well documented analysis above, however the “mutually” beneficial solution you propose, that could be reached by mutual concessions by “rational” players, rests on the assumption that in the long run the euro is sustainable as the currency of the European Union.

Unfortunately, this assumption does not stand and it will be a matter of time before the eurozone is torn apart as a common monetary policy will always be suboptimal for some states given the different states of the economy they are facing.

In the long run it would be good for Greece to hold on for now and to time the Grexit together with Spexit and Frexit.

Because these terms will gain more attention sooner rather than later.

At last, an article worth reading. Unfortunately, there is no conclusion. No one dares to even contemplate what it would mean and indeed, whether it would be better or worse to default and leave the Euro. I for one, prefer to live in a barter economy debt free if I had to than in one that there is no hope on earth of ever recovering.

The author correctly perceives that (the lack of) trust is the key. What both this author and Mr. Varoufakis seem to be missing is that Grexit is not the only possible alternative in case an agreement cannot be reached soon. A more probable outcome is the imposition of capital controls before stopping the ELA to Greek banks. These capital controls would likely be long-lasting in the case of Greece. Note that the idea of capital controls as a semi-permanent 2nd best solution within a monetary union has been studied extensively by influential macro economists over the past few years, and that capital controls have been gaining ground at the IMF. Capital controls would isolate the Greek system and impose a minimal cost to the creditors. Capital contols would also be less costly for Greece than Grexit. The latter two facts mean that Mr Varufakis might have less leverage in the negotiations than he appears to think. Unless they are willing to put Grexit in a referendum, and are prepared to denounce debt upon exit. However, the latter would have greater cost for Greece than capital controls which makes it unlikely in a rational game setting.

the politicians of Eurozone, with ECB assistance, have come up with innovative solutions hitherto as some leaders feel the euro is worth saving. If the there is some hope of compromise it will depend on what the ECB feels it can accommodate. Hence if capital controls are used to buy time, which seems to be an option to sustain the Greek banking system, it may be possible to see an “assisted Grexit” which may be presented by the Eurozone leaders as an exceptional event as they did with the haircut of Greek debt. Alternatively buying time could also allow Greece to introduce a referendum of in or out of the euro question as the French and Germans suggested to G. Papandreou. Since Tsipras is a man of the people why not let the people decide.
In the event of assisted Grexit there could be relief both in Greece and the Eurozone since the Eurozone is deemed, with hindsight, to be a badly designed architecture that allowed the inclusion of countries without having a fiscal and political union that is required to have a sustainable currency. Greece may be better off in a managed float of a weaker currency. The irony is that quantitative easing has succeeded to weaken the euro and it can help the countries of the South which had a tough time with a strong euro.

I agree that Capital Controls (Cyprus style) would be the probable immediate consequence of not reaching an agreement before 28/2/15 (or 16/2/15).
But that would just be the intermediate solution until the practicalities of doing an orderly Grexit (including changing the legal feramework for this to be legal) is done. An orderly Grexit would also mean that there is an agreed haircut on the debt or agreement for the debt to be denominated in the new Greek currency or some other agreed legal way on defaulting on the debt without legal recource in the future by the Creditors (especially the Official EU creditors).
A disorderly Grexit (ie a unilateral decision by Greece) would risk getting Greece coimpletely out of the EU and that would be a complete disaster.
Let’s hope that an agreement can be reached.

The problem resides in the fact that Greece never belonged in the Euro in the first place. Its presence in the Euro was perhaps the primary reason why Cyprus suffered in March 2013 – other reasons such as corruption and incompetence in Cyprus were also a factor of course.

The current Greek government’s approach will most likely not yield any positive results, on the contrary, it has already accentuated the division between Greece and creditor nations, which is rather dangerous.

The most important thing at the moment is for Cyprus to initiate an expedited isolation policy, to the extend that it’s possible, from Greece and hedge against any negative developments there. Cyprus can no longer pretend that Greece is its faithful ally as it is ironically, the source of many of it problems. The delusion of a Greek motherland is over.

Whether we like it or not, the Greek electorate has spoken. They have had enough of austerity. Tsipras is bound by the promises he was voted into Givernment, and he means them. Grexit is, in my humble opinion, just a matter of time given resisytance of the north.

Trying to find a technical solution to a political problem has no reasonable grounds. Concluding that a static ratio of Debt/GDP (in a period when GDP free falls) against a generic benchmark indicates that a whole nation is bankrupt has no reasoning behind it either. Accepting that economic recovery cannot be achieved with deep austerity is the only political way forward… unless Germany doesn’t share the vision of a common European future with the southern countries (very probable). One could say that Germany is the one which buys time before the failed malfunctioning monetary union collapses. Until then, it just mounts up fiscal surpluses for future german generations

I see that many well-known academics have read and commented a nice but not very informative account of probable events.

Dear academics and practitioners i beg you to do the following: inform the readers what are the “technical rules” of a Grexit. For example, we can assume capital controls (Friday midnight…) but then, how should the currency-peg (if any…) work, what does it really mean for the banks’ balance sheets, what if i hold USD/CHF etc etc. I believe this is an area of both political and technical proactive brainstorming worth reading.

After Cyprus eventual “rebound” (post capital restrictions +haircut) I am less convinced that a Euro exit is catastrophic, although I am not an advocate.

Yanis Varoufakis, Greece’s new finance minister, is a professor of mathematical economics who specializes in game theory. But his negotiating technique – unpredictable oscillations between aggressiveness and weakness – is the opposite of what game theory would dictate. Varoufakis’s idea of strategy is to hold a gun to his own head, then demand a ransom for not pulling the trigger.